Summary

• Stablecoins are cryptoassets linked to assets such as fiat currencies or precious metals.

• Stablecoins are designed to maintain relatively stable prices so that users avoid the risk of volatility common in cryptocurrency markets.

• Stablecoins are divided into three types: legal currency support, cryptocurrency support and algorithm support.

• Stablecoins have strong practicality and high market value, and have gradually attracted close attention from regulatory agencies.

Introduction

Not all cryptocurrencies fluctuate in price. In fact, stablecoins are designed to maintain a fixed price. In the cryptocurrency space, currencies and tokens can collapse overnight. If there is a currency that has the advantages of blockchain and can track more stable assets, the demand will be very strong. If you haven’t started trading or investing with stablecoins yet, it’s worth taking a closer look at the concept of stablecoins and their pros and cons.

What is a cryptocurrency stablecoin?

Stablecoins are digital assets that track the value of fiat currencies or other assets. For example, you can buy tokens linked to the US dollar, euro, Japanese yen or even gold and oil. Holders can use stablecoins to lock in profits and losses and transfer value at a stable price on a peer-to-peer blockchain network.

The prices of Bitcoin (BTC), Ethereum (ETH) and other altcoins have long been volatile. While this brings a lot of speculative opportunities, it does have drawbacks. Due to the volatility of cryptocurrency prices, it is difficult to use it as a daily payment method. For example, a merchant sells coffee for $5 and receives payment in Bitcoin, but the Bitcoin depreciates by 50% the next day. This poses significant challenges to business planning and operations that accept cryptocurrency payments.

Previously, cryptocurrency investors and traders were unable to lock in profits or avoid volatility if cryptocurrencies were not converted back to fiat currency. The advent of stablecoins provides a simple solution to this problem. Today, using stablecoins such as TrueUSD (TUSD) allows you to buy and sell easily without being affected by cryptocurrency fluctuations.

How do stablecoins work?

Developing a token that tracks the price or value of another asset requires a peg mechanism. There are various ways to implement this mechanism, and most rely on placing another asset as collateral. Some mechanisms may be more effective, butstill no guarantee that hooking is foolproof.

Stablecoin backed by fiat currency

Stablecoins backed by fiat currencies store fiat currencies such as US dollars or British pounds as reserves. For example, each TUSD is backed by $1 as collateral. Users can then exchange fiat currency for stablecoins at the pegged rate, and vice versa.

Cryptocurrency-backed stablecoin

Stablecoins backed by cryptocurrencies operate similarly to stablecoins backed by fiat currencies. The difference is that the reserve does not require U.S. dollars or other currencies, but is instead backed by cryptocurrency. Due to the high volatility in the cryptocurrency market, stablecoins backed by cryptocurrencies often have over-collateralized reserves in order to combat price fluctuations.

Cryptocurrency-backed stablecoins use smart contracts to manage minting and burning. In this way, users can independently audit contracts and the process is more reliable. However, some stablecoins backed by cryptocurrencies are run by decentralized autonomous organizations (DAOs) where the community can vote for project changes. In this case, users can participate or trust the DAO to make the best decisions.

The specific example is as follows: To mint 100 DAI pegged to the US dollar, you need to provide 150 US dollars (i.e. 1.5 times) of cryptocurrency as collateral. The minted DAI can be used by users at will, and can be transferred, invested, or simply stored as is. To redeem the collateral, you need to pay 100 DAI. However, if the collateral price falls below a certain mortgage rate or loan value, you will face forced liquidation.

When the stablecoin is lower than 1 US dollar, this mechanism will develop incentives for holders and return the stablecoin as collateral. This reduces the token supply, bringing the price back to $1. When the price is above $1, the mechanism incentivizes users to create tokens, increasing supply and lowering the price. DAI is one example, but not all cryptocurrency-backed stablecoins rely on a combination of game theory and on-chain algorithms to maintain price stability.

Algorithmic Stablecoin

Algorithmic stablecoins do not require reserves and use other methods, namely algorithms and smart contracts to manage the issuance supply of tokens. This model is much less common than stablecoins backed by cryptocurrencies or fiat, and is more difficult to operate smoothly.

The algorithmic stablecoin system will reduce the token supply if the price falls below the tracked fiat price. This can be achieved through lock-up staking, burning or buyback. If the price exceeds the fiat value, new tokens will flow into the market, reducing the value of the stablecoin.

What are the advantages of stablecoins?

Stablecoins are versatile and powerful for investors, traders, and cryptocurrency users. The main advantages include:

1. Stablecoins can be used for daily payments. Businesses and individuals alike value stability. Cryptocurrency prices are volatile, so they are not yet widely used for daily payments. Stablecoins are widely recognized for their good performance in maintaining pegs and are suitable for daily use.

2. Stablecoins have the advantage of being backed by the blockchain. Receive stablecoins wherever you are with a compatible cryptocurrency wallet that can be created for free in seconds. Double spending and fake transactions are also nearly impossible to occur. Various characteristics give stablecoins amazingly rich functions.

3. Stable currency is a "sharp tool" for traders and investors to hedge against investors. Allocating a certain proportion of the investment portfolio to stablecoins can effectively reduce the overall risk. Such a portfolio is overall more resistant to market price fluctuations, while traders and investors can still have some funds on hand ready to wait for opportunities. Alternatively, you can sell cryptocurrencies for stablecoins when the market is down and buy them back at a lower price (i.e. short selling). Opening and closing positions is easy with stablecoins, without the need to move funds off-chain.

What are the disadvantages of stablecoins?

Although stablecoins help promote the widespread application of cryptocurrencies, they still have certain limitations:

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1. Stablecoins cannot guarantee to maintain the peg. While some large projects have performed well in the past, many have failed. If there are frequent issues with maintaining a stablecoin's peg, it could suddenly become worthless.

2. Lack of transparency. Not all stablecoins publicly release full audits, and many only provide attestations periodically. Private accountants would perform such work on behalf of stablecoin issuers.

3. Stable coins backed by legal currency are more centralized than other cryptocurrencies. Collateral is held by a centralized institution and may be subject to external financial regulation. Therefore, centralized institutions have considerable control over the tokens. Users also need to trust that the issuer actually holds the so-called reserves.

4. Cryptocurrency collateral and non-collateral tokens are highly dependent on community operations. Cryptocurrency projects usually adopt open governance mechanisms, and users have a say in the development and operation of each project. So you need to get involved or trust the developers and community to run the project responsibly.

Typical example of stablecoin

Cryptocurrency-backed stablecoin: MakerDAO (DAI)

DAI is a cryptocurrency-backed and A stablecoin tracking the US dollar in Ethereum. The token is managed by the MakerDAO community, which holds the governance token MKR. MKR can be used to create and vote on proposals to change projects. In order to cope with the price fluctuations of cryptocurrency, DAI adopts an over-collateralization mechanism, and users can participate in Collateralized Debt Positions (CDP) to manage collateral. The entire process runs through smart contracts.

Stablecoin backed by fiat currency: TrueUSD (TUSD)

TUSD is a stable currency that is pegged to the US dollar and can be independently verified. It is the first stablecoin to programmatically control minting through instant on-chain verification of USD reserves held off-chain. TUSD's reserves are monitored using Chainlink reserve certificates, so holders can independently verify whether their TUSD holdings are backed by US dollar reserves.

Are stablecoins regulated?

Stablecoins uniquely combine fiat currencies with cryptocurrencies, attracting the attention of global regulators. Because of their ability to maintain price stability, stablecoins have many other uses besides speculation. Stablecoins enable high-speed transactions at low cost and globally. Some countries are even trying to create their own stablecoins. Stablecoins, as a type of cryptocurrency, are likely to be equally regulated in their jurisdictions as other cryptocurrencies. Issuing stablecoins with fiat reserves may also require regulatory approval.

Conclusion

Nowadays, it is difficult to find investors or traders who have never held stablecoins. Stablecoins are often stored on cryptocurrency trading platforms so that traders can quickly profit from new market opportunities. Stablecoins can be used to open and close positions without converting them into fiat currencies. In addition to trading and investing, stablecoins can be used for payments and international transfers.

Although stablecoins are an integral part of cryptocurrencies and promote the construction of a new financial system, the risks should not underestimate. Stablecoin project peg failures, loss of reserves, and litigation issues frequently occur. So while stablecoins are versatile and feature-rich, it’s important to remember that stablecoins are still cryptocurrencies and carry similar risks. Diversifying your portfolio can reduce risk. But before investing or trading, please be sure to do your own research, invest rationally, and act within your capabilities.

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